Copyright © 1999 Robert L. Sommers, all rights reserved.
May, 1999 Hot Topics
Last month's Hot Topics involved the non-tax aspects of growing your business by acquiring similar companies. The process involves four distinct steps: (1) identifying opportunities within your industry; (2) evaluating the target company for assets and profitability; (3) negotiating the purchase price (usually a percent of gross income for 6-12 months or a specific dollar amount paid over 2-3 years); and (4) maximizing the tax benefits. This month's Hot Topics will focus on the tax issues.
Invariably, businesses are acquired for their intangible assets (goodwill, location, customer lists, databases, location, name recognition, trademarks) rather than tangible assets (inventory, supplies, furniture or equipment).
Example: Assume you are interested in increasing your sales by purchasing a competitor ("Target"). Target's seller wants $80,000 for his business which has $5,000 of inventory. You have decided that Target's intangibles, consisting of its Yellow Page adver- tisement, customer lists, name recognition in the community and its telephone number, are worth purchasing. After negotiations, you buy the business for $65,000, payable in two years at $3,000 a month, including interest. The purchase price is allocated as follows:
1. Inventory: $5,000
2. Yellow Page Ad: $15,000
3. Customer list: $15,000
4. Telephone number: $5,000
5. Covenant not to compete: $1,000
6. Balance as goodwill: $24,000
All business acquisitions involve three main issues: (1) What amount of the purchase price may be deducted by the purchaser? (2) Over what period of time must the purchase price be deducted? and (3) What are the tax consequences to the Seller?
If the seller's business is incorporated, the buyer has a choice of purchasing the stock of the seller’s shareholders or the assets of the business. It is preferable to purchase business assets, rather than stock for two reasons. First, purchasing stock means that the purchaser "steps-into-the-shoes" of the seller, and acquires all existing and potential liabilities associated with the business. These liabilities includes corporate taxes owed, pending or threatened lawsuits, and any claims involving the corporation's business.
Second, if the corporation is a "C" corporation (a separate taxable entity) a purchase of stock does not permit the buyer to write off any of the purchase price. Assume in our example, that purchaser bought the seller's stock, the seller would receive a capital gain (or loss) on the sale; however, the buyer would not be permitted to write off the business assets because he did not buy them directly.
Note: Purchasing a C corporation’s assets may cause problems for the seller since the corporation is taxed on the sale and then the shareholders are taxed again on the distribution of proceeds from the corporation. The lesson: Sellers who plan to eventually sell their businesses should avoid operating as C corporations whenever possible.
The purchase of a business is a capital expenditure which means that it cannot be deducted in the year of purchase, but must be depreciated over the useful life of the assets acquired or, in the case of intangibles (which do not have a useful life) amortized (deducted ratably) over a period established by the tax law. The purchase is not of the business itself, but rather the components that comprise the business. Thus, each category of asset (inventory, furniture, goodwill, covenant not to compete) must be allocated a portion of the purchase price.
Taxpayers who purchase or sell a business are actually engaged in a multiple asset transaction and must allocate the payment among all the assets.
With an asset purchase, the issue becomes the length of time used for the deductions, and that depends on the classification of assets. Under prior law, goodwill could not be deducted, so purchasers went to great lengths to classify assets as customer lists, contracts, and covenants not to compete, to avoid the stigma of goodwill. Currently, goodwill is amortizable over 15 years.
While the change to allow the 15-year amortization for goodwill was considered favorable to taxpayers, Congress also mandated that most intangible assets that formerly had much shorter useful lives (ranging between 3-5 years) would now fall into the goodwill category. This change means that covenants not to compete, customer lists, business operational know-how and similar assets must also be amortized over 15 years. For small businesses which essentially are buying intangibles, this lengthy write-off period is undesirable.
IRC Sec 1060 requires that sellers and purchasers adopt a consist allocation method and stick to it for tax purposes. Taxpayers use a "residual allocation" method for purchases and sales of businesses, called "applicable asset acquisitions." This method determines the buyer’s basis in the assets, and the seller’s gain or loss.
Note: This method is also used when there is a distribution of partnership property or a transfer of an interest in a partnership, to determine the value of goodwill or going concern value (or similar items), under IRC Sec. 755.
For an acquisition date on or after February 14, 1997, IRC Sec. 1060 uses a 5-class allocation method (IRC Temporary Reg. §1.1060-1T(d) ). The purchase price is allocated in the following order:
Class I: Dollar-for-dollar to cash and demand deposits;
Class II: Highly liquid assets such as certificates of deposit, U.S. government securities, readily marketable stock or securities, and foreign currency;
Class III: All assets other than Class I, II, IV or V assets, both tangibles and non-IRC Sec. 197 intangibles. [Note: IRC Sec 197 intangibles are assets in the nature of goodwill and going concern value, and include workforce in place, information bases, patents, copyrights, licenses and covenants not to compete].
Class IV: IRC Sec. 197 intangibles, except those in the nature of goodwill and going concern value;
Class V: IRC Sec.197 intangibles in the nature of goodwill and going concern value.
The allocations within Classes II, III, and IV are based on the relative fair market value of each asset to the aggregate fair market values of all assets within the class. Any residual payment after allocating to the first four asset classes falls into Class V (IRC Temporary Reg. §1.1060-1T(d)(2)).
Thus, goodwill and going concern value are not determined by a fair market valuation; they retain the residuary allocation value. This change will affect acquisitions where there is a subsequent sale of fewer than all of the IRC Sec. 197 intangibles at a gain, because the gain would have to be allocated to these assets in any event. By separating out the Class IV assets, a more accurate determination of their fair market values in a subsequent sale can be made. Unfortunately, the Category IV and V assets still retain their 15-year amortization periods.
In our example, the inventory would be a Category III asset and valued at $5,000, Category IV assets are worth $36,000, and the balance of $24,000 allocated to Category V assets.
The inventory purchase is not currently deductible, but the purchaser will recover his outlay as the inventory is sold. Unfortunately, the purchaser will deduct $4,000 a year for 15 years for the Category IV and V assets, even though the purchaser will be paying $3,000 a month for 2 years to acquire these assets. Note: The interest paid is currently deductible.
An Asset Acquisition Statement Under Section 1060 (Form 8594) is filed by both buyer and seller when goodwill or going concern value are present (Temporary Reg. §1.1060-1T(h) ). Buyer and seller report: (1) the amount of the purchase price; (2) the allocation of the purchase price to goodwill or going concern value; and (3) any information concerning subsequent adjustments to the purchase price.
Generally, there is a trade-off between capital gains to the Seller and a longer write-off for the Buyer verses ordinary income to the Seller and a faster write-off for the Buyer. In the past, a covenant not to compete was used to generate an ordinary deduction to the Buyer at the cost of ordinary income to the Seller. For instance, if $50,000 of the purchase price was allocated to a covenant not to compete for 2 years, then the Buyer would deduct $25,000 per year and the Seller would report as ordinary income the same amount.
Under IRC Sec. 1060, buyers can no longer write off covenants not to compete over the 1 or 2-year term of the covenant, instead, they must be amortized over 15 years. As a result, covenants not to compete have become a lose/lose proposition for both parties.
Note: For non-tax reasons, a small amount ($1,000) should be allocated to a covenant not to compete since the covenant protects the purchaser against competition from the seller.
Instead of using a covenant not to complete, purchasers have turned to consulting agreements with Sellers as a method to more rapidly deduct a portion of the purchase price. A two-year consulting agreement for $50,000 will permit the Buyer to deduct the payments as made, with the seller declaring the payments as ordinary income.
Use of the consulting agreement could have advantages to the Seller, since he is now in the trade or business of consulting which means he can maintain a Keogh retirement plan for part of the consulting income and is permitted ordinary and necessary business expenses, including a home-office deduction. Unfortunately, consulting agreements and other forms of compensation paid to the seller must be reported to IRS as part of the sale.
Note: If the seller's business was conducted through a "C" corporation and an asset purchase would be subject to a double tax (described above), then use of the consulting agreement, with a single ordinary income tax, may result in a significantly lower overall tax on the transaction.
Likewise, if the seller paid a commission on each sale of his existing customers for a period of two years, these payments would be currently deductible to the buyer and treated the same as consulting agreement payments. This approach is desirable if the purchase price is not fixed, but constitutes a percentage of gross received from the seller's business.
If a portion of the purchase price is allocated to tangible assets that have been depreciated (usually furniture, automobiles and equipment), the depreciated amount is subject to "recapture" (repayment) at ordinary income rates.
Example: Assume seller's business owned a machine that cost the seller $5000 and $3,000 was taken as depreciation. seller's adjusted basis in the machine would be $2,000. If the FMV of the machine is $7,000, then seller has a $5,000 gain ($7,000 FMV - $2,000 adjusted basis). But seller would recapture the $3,000 of depreciation as ordinary income and report a capital gain of $2,000.
Unless the IRS rules otherwise, buyers and sellers are generally bound by any written agreement with respect to the allocation of assets and their fair market values, but IRS may challenge the allocation as "not appropriate" under IRC Sec. 1060(a). Also, a party to a written agreement must show fraud, mistake or undue influence to refute the allocation of assets.
The following examples illustrate the various tax consequences to buyers and sellers. Unless otherwise specified, assume the purchase price is $65,000 allocated as follows - $5,000 to inventory and $60,000 to Category IV and V assets. There is no recapture of depreciation
1. C Corporation Stock Sale —
a. All capital gains to Mike JonesSeller.
b. No deduction for Buyer. Possible deduction for investment interest.
2. Asset Sale by C Corporation —
a. Capital gains to Corporation and ordinary income on interest received, capital gains on distribution to Seller (double tax). Also, interest income distribution might be a dividend and subject to ordinary income tax rates at both the corporate and shareholder levels.
b. Buyer: Inventory as to $5,000, 15-year amortization as to $60,000, and a current deduction for interest paid.
3. Asset Sale by Sole Proprietorship (Schedule "C" unincorporated business) or an S corporation (no built-in gains issues)
a. Capital Gains to Seller, ordinary income on interest received.
b. Buyer: Inventory as to $5,000, 15-year amortization as to $60,000, and a current deduction for interest paid.
4. Asset Sale by Partnership - Generally the same as Example 3 if an IRC Sec. 754 election is made to permit Buyer to allocate the purchase price to the partnership assets. Potential ordinary income tax issue to seller if inventory is appreciated in value.
5. Asset Sale by Sole Proprietorship, S Corporation or Partnership (with 754 election) - $30,000 of the price is allocated to a consulting agreement for two years.
a. Seller(s) Capital gain as to Inventory and Goodwill ($35,000) ordinary income as to $30,000 for consulting agreement. Interest received is ordinary income. Seller(s) may utilize a Keogh Retirement plan for their consulting income and take ordinary and necessary deductions, including a home-office deduction.
b. Buyer: Inventory as to $5,000, 15-year amortization for $30,000 as goodwill and deduction of $30,000 over two years for consulting agreement. Buyer receives a current deduction for interest paid.
6. Asset Sale by C corporation - $30,000 of the purchase price is paid to the shareholder of the Seller as a consulting agreement for 2 years.
a. Seller: Capital gain and double-tax as to $35,000, $30,000 of ordinary income to shareholder of Seller. Seller may utilize a Keogh Retirement plan for consulting income and take ordinary and necessary deductions, including a home-office deduction.
b. Buyer: Same as 5b above.
The purchase of a business can be an advantageous way to grow your business. However, purchasing intangibles while avoiding the stigma of a 15-year amortization will take careful planning. Buyers should consider using a consulting agreement for part of the purchase to generate a faster write-off.
Understanding the tax consequences of the business purchase and how to minimize them will go a long way toward insuring success.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**